Rhonda owns 50% of the stock of Peach Corporation. She and the other 50% shareholder, Rachel, have decided that additional contributions of capital are needed if Peach is to remain successful in its competitive industry. The two shareholders have agreed that Rhonda will contribute assets having a value of exist200,000 (adjusted basis of exist15,000) in exchange for additional shares of stock. After the transaction, Rhonda will hold 75% of Peach Corporation and Rachel's interest will fall to 25%

a. What gain is realized on the transaction? How much of the gain will be recognized?
b. Rhonda is not satisfied with the transaction as proposed How will the consequences change if Rachel agrees to transfer exist1,000 of cash in exchange for additional stock? In this case, Rhonda will own slightly less than 75% of Peach and Rachel's interest will be slightly more than 25%.
c. If Rhonda still is not satisfied with the result, what should be done to avoid any gain recognition?

Explanation:

The transaction is fully taxable because Rhonda, the sole transferor of property, does not have control immediately after the transaction. Therefore, all of the realized gain is recognized.

Amount realized—stock                                                 $200,000

Less: Adjusted basis of property transferred                  (15,000)

Realized gain                                                                   $185,000

Recognized gain                                                             $185,000

b. With the change, Rhonda is trying to avoid recognizing the $185,000 gain. The plan involves Rachel becoming a transfer of property along with Rhonda so that together they would meet the 80% control test. If Rhonda is part of a group that meets the control test, she would avoid recognizing the gain. However, this plan will not be successful. Rachel’s interest cannot be counted since the value of the stock she would receive is relatively small compared to the value of the stock she already owns. In addition, Rachel’s contribution would be made primarily to qualify Rhonda for § 351 treatment.

c. The following alternatives would enable Rhonda to avoid gain recognition:

•    Rhonda can transfer property that has not appreciated in value. For example, if she were to contribute $200,000 of cash to Peach, Rhonda would not recognize gain on the transaction.

•    Rachel could contribute property of an amount that is not small relative to the value of the stock already owned. By doing so, she would be considered a transfer  of property along with Rhonda, and together, they would have control. As a result, Rhonda would avoid gain recognition. For example, if the value of Rachel’s stock is worth approximately $200,000 prior to the contribution, a transfer of at least $20,000 would likely be sufficient to avoid the relative-small-in-value test.

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